With the proliferation of blockchain-based assets, the need to exchange these assets amongst counterparties has significantly increased. As thousands of new tokens are introduced, including the tokenization of traditional assets, this need is magnified. Whether exchanging tokens for speculative trading motivations or converting to access networks via their native utility tokens, the ability to exchange one cryptoasset for another is foundational for the larger ecosystem. Indeed, there is a potential energy in assets, and realizing this energy, i.e., unlocking capital, requires not only asserting ownership, which blockchains have immutably allowed for, but the ability to freely transfer and transform these assets.
As such, the trustless exchange of tokens (value) is a compelling use case for blockchain technology. Until now, however, crypto enthusiasts have largely settled for trading tokens on traditional centralized exchanges. A new method and system for digital asset transaction is needed because, just as Bitcoin dutifully emphasized, in regards to peer-to-peer electronic cash, the main benefits are lost if a trusted third party is still required to prevent double-spending, so too are the main benefits of decentralized assets lost if they must pass through trusted, gated, centralized exchanges.
Trading decentralized tokens on centralized exchanges doesn't make sense from a philosophical perspective, as it fails to uphold the virtues these decentralized projects espouse. There are also numerous practical risks and limitations in using centralized exchanges which are described below. Decentralized exchanges (DEXs) have sought to address these issues, and in many cases have succeeded in alleviating security risks by using blockchains for disintermediation. However, as DEX capability becomes crucial infrastructure for the new economy, there is substantial room for performance improvement.
There are three primary risks in centralized exchanges: 1) lack of security; 2) lack of transparency; and 3) lack of liquidity.
Lack of security arises from users typically surrendering control of their private-keys (funds) to one centralized entity. This exposes users to the possibility that centralized exchanges fall prey to malicious hackers. The security and hacking risks facing all centralized exchanges are well known, yet are often accepted as “table stakes” for token trading. Centralized exchanges continue to be honeypots for hackers to attack as their servers have custody over millions of dollars of user funds. Exchange developers can also make honest, accidental errors with user funds. Simply, users are not in control of their own tokens when deposited at a centralized exchange.
Lack of transparency exposes users to the risk of dishonest exchanges acting unfairly. The distinction here is by the exchange operator's malicious intentions, as users are not truly trading their own assets on centralized exchanges, but rather, an IOU. When tokens are sent to the exchange's wallet, the exchange takes custody, and offers an IOU in its place. All trades are then effectively between users' IOUs. To withdraw, users redeem their IOU with the exchange, and receive their tokens to their external wallet address. Throughout this process there is a lack of transparency, and the exchange can shutdown, freeze your account, go bankrupt, etc. It is also possible that they use user assets for other purposes while in custody, such as lending them out to third parties. Lack of transparency can cost users without a total loss of funds, such as in higher trading fees, delays at peak demand, regulatory risk, and orders being front ran.
Lack of liquidity is another inadequacy of centralized exchange. From the point of view of exchange operators, fragmented liquidity inhibits entry by new exchanges because of two winner-takes-all scenarios. First, the exchange with the greatest number of trading pairs wins, because users find it desirable to conduct all their trades on one exchange. Second, the exchange with the largest order book wins, because of favorable bid-ask spreads for each trading pair. This discourages competition from newcomers because it is difficult for them to build up initial liquidity. As a result, many exchanges command a high market share despite user complaints and even major hacking incidents. It's worth noting that as centralized exchanges win market share, they become an ever-larger hacking target.
From the point of view of users, fragmented liquidity significantly reduces user experience. In a centralized exchange, users are only able to trade within the exchange's own liquidity pools, against its own order book, and between its supported token pairs. To trade token A for token B, users must go to an exchange that supports both tokens or register at different exchanges, disclosing personal information. Users often need to execute preliminary or intermediate trades, typically against BTC or ETH, paying bid-ask spreads in the process. Finally, the order books may not be deep enough to complete the trade without material slippage. Even if the exchange purports to process large volumes, there is no guarantee that this volume and liquidity is not fake. The result is disconnected silos of liquidity and a fragmented ecosystem that resembles the legacy financial system, with significant trading volume centralized on few exchanges. The global liquidity promises of blockchains hold no merit within centralized exchanges.
On the other hand, current decentralized exchanges have their own inadequacies. Decentralized exchanges differ from centralized exchanges in part because users maintain control of their private-keys (assets) by performing trades directly on the underlying blockchain. By leveraging the trustless technology of cryptocurrencies themselves, they successfully mitigate many of the abovementioned risks surrounding security. However, problems persist in regards to performance and structural limitations. Liquidity often remains an issue as users must search for counterparties across disparate liquidity pools and standards. Fragmented liquidity effects are present if DEXs or dApps at large don't employ consistent standards to interoperate, and if orders are not shared/propagated across a wide network. The liquidity of limit order books, and, specifically, their resiliency, i.e., how fast filled limit orders are regenerated, can significantly affect optimal trading strategies. The absence of such standards has resulted not only in reduced liquidity, but also exposure to an array of potentially insecure proprietary smart contracts.
Furthermore, since trades are performed on chain, DEXs inherit the limitations of the underlying blockchain, namely: scalability, delays in execution (mining), and costly modifications to orders. Thus, blockchain order books do not scale particularly well, as executing code on the blockchain incurs a cost (gas), making multiple order-cancellation cadences prohibitively expensive.
Finally, because blockchain order books are public, the transaction to place an order is visible by miners as it awaits being mined into the next block and placed into an order book. This delay exposes the user to the risk of being front run and having the price or execution move against him. Front running is the illegal practice of a stockbroker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. In decentralized exchanges, front-running means someone tries to mine transactions before mining other transactions that are already in the pending transaction pool (mempool). This can be achieved by specifying a higher transaction fee (gas price), and if the front-runner happen to be a miner he can order pending transactions in a way that benefits himself.
Therefore, there is an urgent need to develop a method and system to solve the aforementioned issues.